Alerts and Updates
U.S. Supreme Court Sets Higher Pleading Standard for Securities Fraud Complaints
July 10, 2007
With respect to allegations in a securities fraud complaint, the United States Supreme Court held in Tellabs v. Makor Issues & Rights Ltd. (June 21, 2007), by an 8-1 vote, that, to qualify as a "strong inference of scienter" within the meaning of Section 21D(b)(2) of the Private Securities Litigation Reform Act of 1995 (the "PSLRA"), an inference of scienter "must be more than merely plausible or reasonable." The Court ruled that "[a] complaint will survive only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any plausible opposing inference one could draw from the facts alleged."
The PSLRA requires plaintiffs to state with particularity both the facts (i) constituting the alleged violation and (ii) evidencing scienter, which is construed as the defendant's intention to "deceive, manipulate or defraud." With respect to the latter, plaintiffs must state with particularity facts giving rise to a "strong inference" that the defendant acted with this required state of mind (i.e., scienter). The Court found this standard to be most in line with the PSLRA's twin goals of curbing frivolous, lawyer-driven litigation, while preserving investors' ability to recover on meritorious claims. In practice, this decision imposes more stringent standards on securities fraud shareholder complaints and, therefore, makes it easier for defendants in such actions to have the complaint dismissed.
Certain shareholders of Tellabs alleged that Tellabs and its former chief executive officer and president Richard Notebaert ("Notebaert"), as a "controlling person" under the Securities Exchange Act of 1934 (the "Exchange Act"), had engaged in securities fraud in violation of Section 10(b) of the Exchange Act and accompanying SEC Rule 10b-5. Specifically, the plaintiffs alleged that Notebaert:
- made statements indicating that demand for Tellabs' flagship networking device, the TITAN 5500, was continuing to grow, when in fact demand for the product was waning;
- made statements indicating that the TITAN 6500, Tellabs' next-generation networking device, was available for delivery, and that demand for that product was strong and growing, when in truth the product was not ready for delivery and demand was weak;
- falsely represented Tellabs' financial results for the fourth quarter of 2000; and
- made a series of overstated revenue projections when demand for the TITAN 5500 was drying up and production of the TITAN 6500 was behind schedule.
The U.S. District Court for the Northern District of Illinois dismissed the plaintiffs' original and amended complaint for failing to sufficiently plead that Notebaert acted with scienter under the standards set forth in the PSLRA. The U.S. Court of Appeals for the Seventh Circuit reversed the District Court's decision in relevant part. In contrast to the District Court, the Seventh Circuit concluded that the shareholders had sufficiently alleged that Notebaert acted with scienter, holding that a complaint should survive "if it alleges facts from which, if true, a reasonable person could infer that the defendant acted with the required intent." The Seventh Circuit added, "[i]f a reasonable person could not draw such an inference from the alleged facts, the defendants are entitled to dismissal."
Supreme Court's Opinion
The Supreme Court held that, to qualify as "strong" within the meaning of Section 21D(b)(2) of the PSLRA, an inference of scienter must be more than merely plausible or reasonable - it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent. In its opinion, the Court noted that Congress did not define the term "strong inference"1 and the Courts of Appeals had divided on its interpretation. Because of this uncertainty perpetuated by Congress and the Courts of Appeals, the Court stated that it was "task[ed]" with prescribing a "workable construction" of the "strong inference" standard. The Court determined that a reviewing court must ask: "When the allegations are accepted as true and taken collectively, would a reasonable person deem the inference of scienter at least as strong as any opposing inference?"
Overview of Section 10(b), Rule 10b-5 and the PSLRA
Section 10(b) of the Exchange Act forbids the "use or employ, in connection with the purchase or sale of any security ..., [of] any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe as necessary or appropriate in the public interest or for the protection of investors." As prescribed by the SEC, Rule 10b-5 makes it unlawful (a) to employ any device, scheme or artifice to defraud, (b) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made not misleading, or (c) to engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security. To establish liability under Section 10(b) and Rule 10b-5, a private plaintiff must prove that the defendant acted with scienter, "a mental state embracing intent to deceive, manipulate or defraud."
The PSLRA was enacted to curb abusive Section 10(b) actions, described by Congress as "nuisance filings, targeting of deep-pocket defendants, vexatious discovery requests and manipulation of class action lawyers." Under the PSLRA's heightened pleading standards, any private securities complaint alleging that the defendant made a false or misleading statement must (i) specify each statement alleged to have been misleading [and] the reason or reasons why the statement is misleading and (ii) state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.2
The Court's Prescriptions and Analysis
The Court prescribed the following steps for courts faced with a motion to dismiss a Section 10(b) action:
- In compliance with long-settled law, when faced with a motion to dismiss a Section 10(b) action, courts must accept all factual allegations in the complaint as true.
- Courts must consider the complaint in its entirety, as well as other sources courts ordinarily examine when ruling on motions to dismiss. In particular, the Court stated that "[t]he inquiry is whether all of the facts alleged, taken collectively, give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in isolation, meets that standard."
- In determining whether the pleaded facts give rise to a "strong" inference of scienter, courts must take into account plausible opposing inferences.
Noting that the strength of an inference "cannot be decided in a vacuum," the Court explained that the inquiry must be "inherently comparative." The Court instructed courts to consider plausible nonculpable explanations for the defendant's conduct, as well as inferences favoring the plaintiff. The Court surmised that "[a] complaint will survive only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any plausible opposing inference one could draw from the facts alleged."
The Court then undertook to illustrate the application of its standard. Tellabs had argued that, because Notebaert did not have any financial motive to mislead shareholders (he did not sell any company stock during the relevant period), he must have lacked scienter. In response, the Court stated that, while personal financial gain "may weigh heavily in favor of a scienter inference ... the absence of a motive allegation is not fatal," reminding that all allegations must be considered collectively. Tellabs also argued that several of the plaintiffs' allegations were too vague or ambiguous. The Court agreed that omissions and ambiguities argue against an inference of scienter, but again stated that the allegations must be considered collectively. The Court, however, did not decide whether the plaintiffs met the standard in the instant case, but remanded the case to the Seventh Circuit so that it could apply its new standard.
Justice Scalia's Concurring Opinion
In his concurring opinion, Justice Scalia posited that a "strong inference" of scienter means an inference that is more plausible than the inference of innocence. Relying on his "natural reading" of the statute and logic, Justice Scalia "fail[ed] to see how an inference 'at least as compelling as any opposing inference' [could] conceivably be called a 'strong inference.'" Justice Scalia further explained: "There is no indication that the statute ... was meant to relax the ordinary rule under which a tie goes to the defendant. To the contrary, it explicitly strengthens that rule on extending it to the pleading state of a case."
Justice Stevens' Dissenting Opinion
In his dissenting opinion, Justice Stevens suggested that a "strong inference" is roughly equivalent to probable cause, meaning that the inference did not necessarily need to be the most likely. Justice Stevens explained that "[t]he basic purpose of the heightened pleading requirement in the context of securities fraud litigation is to protect defendants from the costs of discovery and trial in unmeritorious cases." Likening such a securities fraud claim to a criminal proceeding, Justice Stevens added that "discovery may also invade the privacy interests of the defendants and their executives, [and] like citizens suspected or having engaged in criminal activity; those defendants should not be required to produce their private effects unless there is probable cause to believe them guilty of misconduct." Justice Stevens also stressed that the foregoing probable cause standard is familiar to courts and that using a probable cause standard would avoid forcing courts to take into account plausible opposing interests. To wit, Justice Stevens opined that "there are times when an inference can be deemed strong without any need to weigh competing inferences."
What This Means to Private Securities Litigation
The Tellabs decision is a positive ruling for companies and executives, making it more difficult for shareholder-plaintiffs to sue companies and executives or win substantial damages. The Court made clear that competing inferences must be weighed when confronted with a motion to dismiss. As a result, it will be easier for company and executive defendants to succeed in the dismissal of a shareholder-plaintiff securities fraud complaint and thereby avoid the costly, time-consuming and intrusive process of discovery.
For Further Information
If you have any questions regarding this decision, including how it may affect you or your company, please contact one of the members of the Securities Law Practice Group or the lawyer in the firm with whom you are regularly in contact.
- The Court used the dictionary meaning of "strong" as "persuasive, effective, and cogent" or "powerful to demonstrate or convince" and "inference" as "a conclusion [drawn] from known or assumed facts or statements."
- The Court noted that the question whether and when recklessness satisfies the scienter requirement was not presented in Tellabs case. The Court added, however, that every Court of Appeals that has considered the issue has held that a plaintiff may meet the scienter requirement by demonstrating the defendant acted intentionally or recklessly, "though the Circuits differ on the degree of recklessness required."
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